Why are so many people so unsuccessful at investing and constantly behaving against their own long term interests? 46% of Americans could not come up with $400 to cover an emergency expense! Why do we mismanage our resources, give into impulse shopping and short term behavior that harms our financial future? 33% of the population has debt in collections!
Many questions like these and more are under investigation in the field of behavioral economics. The good news is that some of this behavior can now be explained in terms of the way our minds work. Perhaps we can implement financial hacks so we are not our own worst enemies. We can set ourselves up for success in spite of ourselves. Here are some ideas from leading experts in this field that could help one achieve investment and financial success.
We have a primitive side of our brain that seems to lead us astray when it comes to our finances. Our brains evolved for surviving in hunter-gatherer tribes, not for following economic trends, the stock market and watching 24/7 sensational news coverage. We evolved to survive a threat in the moment using our “fight or flight” response mechanisms. But, how do we behave when the threat is not a saber tooth tiger, but a screen flashing alarming financial data? Unfortunately our minds perceive the threat in the same way, which can lead to poor choices. Here are some highlights from some of the greatest thinkers on these topics:
I am particularly interested in Jason Zweig’s research and book titled Your Money & Your Brain. The book has been out a long time now, but the information is just as relevant today. I think one of the most important quotes from the book is:
“The best investors make a habit of putting procedures in place, in advance, that help inhibit the hot reactions of the emotional brain.”
What are some practical ways to apply Mr. Zeig’s advice?
1. Have a balanced portfolio tailored to your own individual tolerance for risk.
Currently the market is beginning to experience increased turbulence. Our brain may perceive this as a threat or danger, therefore we may make some short term decisision that is not healthy for us in the long run. Our brain is flashing red alert, so we are protecting ourselves for survival in the short run. Because I have a portfolio tailored to my age, risk tolerance, etc., I am not too worried. If the market tanks, there will be a kind of floor on the losses because I am not 100% exposed to stocks.
Another couple of interesting points from Mr. Zweig’s research is that the brain activity of a person that’s making money on their investments is indistinguishable from a person who is high on cocaine or morphine. He also explains how financial losses and gains have profound physical effects on the body and the brain. Given all these concepts, here are several ideas you could put in place to protect your investments from these “hot reactions” and the monkey brain:
2. Gamble a small amount.
Have a balanced portfolio so you do not over react when the market has it’s normal corrections. Mr. Zweig says:
“Put at least 90% of your stock money into a low-cost, diversified index fund that owns everything in the market. Put 10%, tops, at risk on speculative trades. Be sure this “mad money” resides in a separate account from your long-term investments; never mingle them. Never add more money to the speculative account. (It’s especially important to resist that temptation when your trades have been doing well.) If you get wiped out, close out the account.”
Remember the 90% needs to be diversified. I am a bit more conservative than Mr. Zweig suggests, but the main point here is the 10% he talks about. I am no psychologist, but for me the 10% of “crazy” money serves a useful purpose. In a small way I am able to play around in risky investments and for lack of a better description, get the gambling and risk taking out of my system. If this 10% makes it big, great, we all go on vacation. If not, life goes on and our future is still secure.
Have money automatically put into an investment account each month and make it hard to access it and touch it. You want to fence it off so that you do not over react to any single event or spend it right away. I find that often times if I have immediate access to the money, I will most likey “find” something to spend it on.
4. Know thyself.
Know your sensitivity to fluctuations and risk. If you loathe risk then you may be one for more of a slow and steady approach to investing. Perhaps you’re the type that wants to be ultra “safe” (if such a thing exists). You sleep well at night with a simple strategy of pay off the house and put extra money in a savings account. I have known families like this and they have fine lives. They are not uber wealthy by any means, but all their needs are met and they are financially secure.
Another great quote from Mr. Zweig that truly captures an amazing reality of money and happiness:
“In 1957, the average American earned $10,000 (adjusted for inflation) and lived without a dishwasher, clothes dryer, TV, or air conditioner. But 35% of people surveyed then said they were “very happy” with their lives. By 2004, personal income had nearly tripled after inflation, yet only 34% of people now said they were “very happy.”
How could this be? Living standards had tripled, yet the number of people that were happy went down. I have personal views and theories on why this is. Part of it has to do with the amount of commercials and media we are bombarded with. The chief aim of this media is to tell you one simple message: You life is not complete unless you buy XYZ product. So, think about the thousands of subtle messages we are sent telling us what we need to buy to enhance our life. There was a lot less of that stuff bombarding us in the 1950’s.
Another theory could have to do with balance in life. Perhaps the pace of change and life is too frantic. People are running faster and faster, and to where? I am not sure why this is, but it seems to clearly prove that a bunch of material stuff does not translate into happiness.
Another scholar I like to read about is last year’s winner of the Nobel prize in economics Richard Thaler. Mr. Thaler studies behavioral economics, which shows that people’s real world decision making is horrible when it comes to money and building wealth. In other words, the short sighted survival “animal” part of our brain takes over in the moment and sabotages our future self. One of my favorite Mr. Thaler quotes is:
“My lazy strategy of doing very little and buying mostly stocks, and then not paying attention, has served me well.” He also suggests that people not watch financial media, he says “paying attention day-to-day is damaging to one’s financial and emotional well being.”
And do not think Mr. Thaler is some academic in an ivory tower, he runs a very successful investment fund that operates in the real world. His work seems to have a couple practical applications and practices that could help:
A. Automate to buy an index fund of stocks and then simply ride the ups and downs over time. In other words, be lazy, do not run around trying to time the market’s ups and downs. In fact, Warren Buffet bet $1 million dollars ten years ago that active investors would not beat the returns of a broad index fund that simply bought a collection of stocks and sat untouched. He won the bet. The work of these scholars outlines why it is so imperative that we automate our way to wealth and create systems that protect ourselves from our “monkey” brain.
B. Do not watch dramatic financial media. Turn off the TV! Too much TV and sensational news is just garbage for our brains. Paying attention too much to financial “news” and sensational shows seems to damage our well being and the returns of our portfolios. Keep this in mind if watching these shows and see them for what they truly are, a form or entertainment probably designed to make one buy more of something.
The Hedonic Treadmill
Another way we trick ourselves is with a mindset of scarcity and never being satisfied with our material acquisitions. We never seem to make enough money no matter how much we make, the fancy car we drive, the big house, the clothes, the expensive meals etc. etc. forever. I have heard people say, “Once I make X amount of money, then I will make enough to save and invest some.” This is a foolish thing to tell ourselves and keeps us from building wealth. Wealth is built like a solid house, one small brick at a time. The constant striving for more and never being satisfied with our material lives is known as the “hedonic treadmill.” Once we get used to a certain lifestyle, it just doesn’t seem to satisfy any longer, leading us to buy more and more, never reaching any level of contentment. This is why we talk so much about gratitude on our site. Many people have what they need each day: they are clothed, fed, housed, entertained, etc.
In conclusion, give some thought to how the way our brains are wired may work against us in terms of building wealth and managing money. Find strategies that work for you and set you up for success. Be sure to focus on the positive and gratitude. Having gratitude for what you already have may make one realize how wealthy they are and join the 35% who say they are truly happy.
Please consult a financial fiduciary professional regarding your particular investment situation. None of this information is meant to address any one person’s particular financial situation.